The Beginner's Guide to Municipal Bonds

New to muni bond investing? Want to get a solid understanding of municipal bond market fundamentals? Look no further! We’ve written this simple 10-part series on municipal bond basics.

What are Municipal Bonds?

We start our guide with a brief overview of muni bonds, the muni market, and other bond basics. We answer the questions, what is a muni bond and how do they work? The simplicity to this surprises many people. When you buy a muni, you’re agreeing to lend the issuer (usually a city or state government) money for a period of time. In exchange, the issuer will agree to pay you interest, at a fixed rate, throughout the term of the bond. Once the bond matures, or comes due, your principal, which is the original loan amount, should be repaid to you in full.

Doesn’t seem too difficult, right? This almost begs the immediate next question we usually get, how do I make money from muni bonds? Well, to answer that, you first have to learn about the two different types of municipal bonds. There are general obligation bonds (GO bonds) and revenue bonds. GO bonds are backed by the taxing power of the issuer and your payments come from tax revenue. Revenue bonds on the other hand are paid out by the income generated by the projects they’re being used to fund. So for example, the famous Golden Gate Bridge was a revenue-paying muni bond whereas that local park bond in anywhere, USA is most likely a GO bond because the park likely doesn’t generate any revenue.

History of Municipal Bonds

To understand the history of municipal bonds in America, we need to go way back to the time of the Renaissance, Italian city-states started the practice of borrowing money from families that were big in the banking world. While it’s thought that borrowing among U.S. cities began as far back as the 17th century, it wasn’t until the early 1800s when U.S. muni bonds were actually recorded.

The first official muni bond in the U.S. was issued in 1812 by New York City and sought to raise funds for the purpose of building a canal. Six years later, New York State started issuing bonds to finance the construction of the Erie Canal – a $7 million prospect that not only improved the state’s economy, but led to an increase in trading and commerce throughout the country.

Following that, other cities and states began issuing municipal bonds of their own to support infrastructure development and construction. By 1840, the muni bond market was going strong at a remarkable $200 million and rose fivefold over the next four decades. By 1880, there were approximately $1 billion outstanding muni bond issues.

Fast forward to the Great Depression of the 1920s and 1930s. Municipal bonds served as a major bright spot. Around this time, workers began construction on the Golden Gate Bridge, an effort funded primarily through the sale of municipal bonds. Despite the unfavorable economic conditions that plagued the country as a whole, in a show of faith, voters in the Golden Gate Bridge and Highway District approved a $35 million bond issue for which they offered up their homes, farms, and businesses as collateral. The bridge opened in 1937, and the bonds were ultimately paid back in full.

Risks of Muni Bonds

We couldn’t give you a full picture of the muni bond market without discussing the risks of muni bonds. For many, the greatest appeal of muni bonds is the calmness of being able to sleep at night knowing that they have made a sound investment that meets their personal needs. But as attractive as muni bonds may be for all these reasons, there are also some risks inherent in investing.

Bonds with higher interest rates also tend to come with more risk. Opting for a more attractive interest rate could mean putting yourself in a position where you may lose out on interest payments or principal down the line.

One of the biggest risks of muni bonds is the possibility of default. Although this is rare, it can happen. A default occurs when the bond issuer is unable to meet their payment obligation, thereby missing a payment. One thing to note with regard to risk is that municipal bonds may carry insurance in the event of a default. You can also protect yourself by reviewing the credit ratings of the bonds you’re interested in purchasing.

Benefits of Muni Bonds

Municipal bonds can be a great addition to a long-term investment strategy, and in many cases, they may also work as a short-term investment. The key is to evaluate the pros along with the cons when deciding whether to add them to your portfolio. In this section of our guide, we highlighted three primary benefits of muni bond investing:

invest locally

tax benefits

low risk

One of the features that excites us most about municipal bonds is that you can choose to support your local town or city, or a specific project from which you stand to benefit should it get funded and subsequently completed. In other words, you have the potential to not only make a profit on the bonds themselves through interest payments (and a possible resale), but to benefit from the end result of the initiative the bonds are issued to support.

Further, when you earn interest from another source, like a savings account or corporate bond, that interest is taxed as ordinary income. But when you earn interest from a tax-free muni bond, you won’t have to fork over a portion of your profit to federal taxes. Even better, if you purchase municipal bonds issued by your own state, the interest you earn from those bonds may be exempt from state taxes as well.

Lastly, as mentioned above, investing in muni bonds is a relatively low-risk investment. In fact, there has never been a default on a AAA-rated municipal bond and there have been only 71 Moody’s-rated municipal bond defaults in total over the past 45 years.

Munis vs. Stocks, Savings Accounts, and Money Market Accounts

After writing the first half of our muni bond guide we realized that we needed to discuss the fundamental differences between municipal bonds and stocks, saving accounts, and money market accounts.

The primary difference between a municipal bonds and stocks is that with stocks, you own a (usually small) percentage of the corporation (called ‘equity’). If the company makes money, you stand to profit from its earnings in the form of dividend. But if the company performs poorly, you won’t see those sought-after dividends, and the stock price could also suffer by dropping in price.

When comparing muni bonds to FDIC-insured accounts, there are four factors to consider: interest rates, the length of each investment, liquidity, and the minimum investment required. Municipal bonds offer much higher interest rates than their FDIC-insured counterparts. On top of that, the interest earned from munis is exempt from federal income taxes (and sometimes exempt from state tax), whereas interest earned from CDs, savings, and money market accounts is taxed as ordinary income.

Munis vs. Corporate Bonds, Treasury Bonds, and Mutual Bond Funds

Municipal bonds are generally considered to be less risky than corporate bonds. Nevertheless, corporate bonds and municipal bonds are structured in the same fashion: In exchange for lending the issuer (government for munis and companies for corporate bonds) a certain amount of money for a fixed period of time, you’ll get interest payments throughout the term of the bond, with your principal repaid in full once the bond comes due.

There are still differences that you should know about these two financial assets. Here is a brief review:

Default rates: Muni bonds are 50 to 100 times less likely to default than comparably rated corporate bonds.

Returns & Tax status: The average yield on municipal bonds over the past 10 years has been just over 4%, whereas corporate bonds have averaged between 5 and 7%. The interest earned on most muni bonds is exempt from federal taxes and, in some cases, state taxes as well. The interest earned from corporate bonds is subject to taxation at both the federal and state level.

**Market size & liquidity: **As of 2014, the muni bond market topped out at approximately $3.6 trillion. The corporate bond market is much larger, with more than $11 trillion issues outstanding.

Disclosure: Corporate issuers are required to publicly disclose information that could impact their bonds, and bond prices must be disclosed as part of the trading process. Municipal bonds, however, don’t currently have the same disclosure requirements on both the part of issuers and brokers. But rest assured, Neighborly is working to change this! We imagine a future of full and complete transparency where you, the bond buyer, have open access to information and disclosures that will help you better understand your investment decision.

But what about the difference between muni bonds and treasury bonds? Great question! Treasury bonds, or T-bonds for short, are bonds issued by the U.S. Department of the Treasury. When you buy T-bonds, you’re essentially loaning money to the federal government so that it can do things such as pay down national debt or finance general operations. Treasury bonds are issued with a minimum face value of $1,000 and a maturity of over 10 years.

And finally, in this post, we covered the difference between muni bonds and mutual bond funds. Without getting too deep, the primary difference is mutual bond funds allow participants to invest in multiple bond issues without having to worry about individual investment minimums. That’s because these funds are able to pool their participants’ resources to purchase bonds.

Finances, Taxes, and Credit Ratings

Selling the bond for a higher price than what you initially paid and profiting on the face value alone

The first scenario is appealing from a tax perspective because the interest earned on municipal bonds is exempt from federal income taxes, and if you purchase bonds issued by the state in which you reside, the interest may be exempt from state and local taxes as well.

When comparing investment returns from muni bonds verse other assets, keep in mind that you have to calculate the muni’s the tax-equivalent yield. to determine whether taxable corporate bonds or tax-exempt muni bonds are a better overall suitability. There are several online calculators that can help you crunch the numbers.

In this post, we also dove into muni bond credit ratings. A credit rating is essentially a measure of an issuer’s likelihood and financial ability to repay its debts. There are three major rating agencies used to evaluate creditworthiness:

Standard & Poor’s (S&P)

Moody’s

Fitch

S&P and Fitch use the same ratings scale, from AAA (extremely likely to meet financial commitments) to D (default level). Moody’s uses a different scale, from Aaa (highest quality) to C (default).

Bond Defaults and Recoveries

With any investment, you need to be aware of the risks involved. A question we’re asked often is, ‘if I’m investing in the city, how do I know I’ll get my money back?

The good news is that defaults in muni bonds are very rare. For example, did you know that no state has defaulted on a general obligation bond since 1933! Even better, the only two states that defaulted in 1933 eventually paid back all the overdue principal. Compare this to the stock market — where in the Great Recession of 2008, the market dropped over 57% — and muni bonds look that much more reliable as investments.

Understanding what causes bond defaults can help you make smart investment decisions. At the most basic level, muni bonds default when their issuers — states, cities, or communities — find themselves unable to repay their debts in a timely fashion.

Why Invest in Muni Bonds?

There are a number of reasons why you would invest in muni bonds. First and foremost, at Neighborly, we like to tell people that the best part of investing in muni bonds is that you are investing in your community. It’s not a donation — it’s an investment, which means you will receive a return on that investment, as explained above.

When you invest in a municipal bond, you’re investing in a specific place or project. Municipal bonds offer a unique opportunity to make money while supporting your local community. In this regard, muni bonds are a feel good sort of investment, as the area or project you help fund can contribute directly to the betterment of those around you.

Another significant benefit is that the interest earned from muni bonds is exempt from federal taxes, and if you purchase tax-exempt bonds issued by the state in which you reside, that interest will (unsurprisingly) be exempt from state taxes as well.

Many people also invest in munis because they make for a stable, long-term investment. Though there are scenarios in which muni bonds can serve as a smart short-term investment, they are better known to be helpful as part of a long-term savings plan. If you’re looking for a way to lock in relatively stable returns over a long period of time, munis may be a good choice.

Furthermore, if you are not big on taking risks then muni bonds may complement your investment strategy. Because they have historically low default rates, munis often appeal to those hesitant to invest in more volatile instruments like stocks or corporate bonds.

The Future of Muni Bonds

In its current state, the muni bond market can be very limiting for those looking to break in and invest. While established investors and fund managers may have an easier time procuring muni bonds for their respective portfolios, newer and younger investors may have a more difficult time snagging the same opportunities.

The future of the Muni Bond industry, as seen through the eyes of the Neighborly team, is for more transparency, less fees, and more public participation. “This is an exciting time to be part of a community of investors,” says Jase Wilson, CEO of Neighborly. “Public projects are going to get funded and completed with less hassle and fewer delays. Neighborhoods are going to improve without the bureaucratic backlogs that once held them back. The public is going to have a voice and play a real role in shaping strong, vibrant communities.”

In the future, those looking to take part in the muni market will do so without having to worry about the hefty fees that tend to go hand-in-hand with classic broker transactions.

Many of the projects funded by muni bonds are designed to improve communities and infrastructure. It seems counterintuitive to make investment opportunities with significant local impact exclusive and hard to come by. In recent years, there’s been a shift where cities and governments are not just accepting, but embracing the fact that major improvements and undertakings are often reliant on public support, and as such, there needs to be a better way to help individuals get involved.

“Investors are going to want to feel good about where their money is going,” says Wilson. “If you’re going to put your money somewhere, why not invest in a project that means something to you?”